18 December 2010

Bank of Montreal's acquisition of Marshall & Isley may signal the start of a hoped-for wave of regional bank consolidation. But others shouldn't follow its lead when it comes to price.

BMO is buying M&I for $4.1 billion, equivalent to a 33% premium over the prior day's close for a bank hit hard by the financial crisis. M&I has yet to pay back $1.7 billion in Troubled Asset Relief Program funds and has racked up eight consecutive quarterly losses.

No wonder BMO's stock sank nearly 7% Friday. M&I shareholders, on the other hand, aren't complaining. And the announcement had investors speculating about other possible takeovers; shares of banks such as KeyCorp and Regions Financial rose smartly.

Many regional banks are seen as vulnerable because they are finding the road to recovery tough. With demand for loans still tepid, there may be few opportunities, outside mergers, to boost growth.

Deals also could allow weaker banks to be weeded out without hitting the Federal Deposit Insurance Corp.'s already strained funds. "Regulators may encourage many of the more stressed regional banks to sell to stronger regional banks," analysts at CreditSights said in a note Friday. They highlighted U.S. Bancorp, PNC Financial Services Group and BB&T among potential acquirers.

But there still is the small issue of price to consider.

BMO ostensibly is paying one times tangible book value, and with stock. That assumes, though, that M&I's loan book is worth its carrying value. It isn't. In its most recent quarterly filing, M&I shows its loan book has a market value 10% below its balance-sheet value. That tallies with BMO's own estimate of an additional 12% of loan losses.

Apply M&I's market-value estimate, tax-adjusted, and the bank's tangible common equity falls to $1.56 billion. At the adjusted level, BMO, whose own shares trade at 1.8 times book, is actually paying 2.62 times book value. If the market-value adjustment isn't tax-affected, because M&I hasn't been profitable, the multiple soars to more than 20 times.

Even the lower valuation would be rich for a pristine bank whose assets can be counted on to hold their value. That's not the case with M&I, whose loan book still is shaky.

Over the past two months, Standard & Poor's downgraded M&I, while Moody's Investors Service placed the bank on review for possible downgrade. Both firms noted weakness in M&I's commercial real-estate and construction-lending portfolios, which make up more than a third of the loan book.

In its defense, the deal makes strategic sense for BMO, which already owns Chicago-based Harris Bank and is looking to expand in the Midwest. BMO also expects to reap about $250 million in pretax cost synergies. As good as that is, it's still not justification for overpaying.

Bank of Montreal unveiled plans to buy Milwaukee-based Marshall & Ilsley Corp. in a $4.1 billion stock swap, triggering speculation that other faltering U.S. regional banks may be snapped up as well.

Shares of SunTrust Banks Inc., KeyCorp, Regions Financial Corp., Synovus Financial Corp., and Fifth Third Bancorp, all of which have yet to repay $1 billion or more in government aid, rose as investors sought out other possible takeover targets.

"The first question is 'who's next?'" said Chris McGratty, a bank stock analyst at Keefe Bruyette & Woods, which included M&I on a list of 26 possible takeovers in June. However, Mr. McGratty cautioned that other such scenarios may take time to play out.

With the U.S. economy showing signs of life, bank takeover speculation has rarely been as active since the subprime-mortgage meltdown hit. Banks that haven't repaid government aid under the Troubled Asset Relief Program have been a focus of investors.

On Wednesday, stock of Regions, which owes $3.5 billion, surged as much as 5.6% in early trading on rumors that it might be acquired. The same day, BankAtlantic Bancorp Chief Executive Alan Levan said that while the lender has expressed intent in the past to remain independent, "we believe it is in our shareholders' best interest for us to be flexible and open to opportunities as they may be presented."

The Marshall & Ilsley acquisition, the largest U.S. bank acquisition in two years, is the latest in a string of U.S. purchases by Canadian banks, which have weathered the financial crisis and recession better than most U.S. peers.

Unlike U.S. banks, Canada's didn't require bailout funds, avoiding the subprime-mortgage crisis with the help of conservative lending practices and tight regulation.

The Marshall acquisition was the largest U.S. bank deal since PNC Financial Services Group acquired National City Corp. for $5.6 billion in October 2008, according to KBW.

Marshall & Ilsley became vulnerable with pricey acquisitions in Florida and overexpansion in Arizona, triggering an overexposure to construction loans and $4.8 billion in losses since 2007, Mr. McGratty said. Marshall shares had been sliding amid fears over its ability to raise funds to repay $1.7 billion in government aid.

Still, the acquisition came at a 34% premium to Marshall & Ilsley's stock price, based on where the two stocks closed on Thursday.

Alan Villalon, a bank stock analyst First American Funds in Minneapolis, which owned 824,347 Marshall shares, said the deal shows that there are still healthy banking assets, which wasn't so clear in recent weeks after Wilmington Trust was sold at a steep discount.

But the $7.75-a-share offer sparked a 6.5% slide in the stock of Bank of Montreal, commonly referred to as BMO, cut the deal's price tag and reduced the premium. One reason for Friday's slide is that BMO said it plans to write down another $4.7 billion in Marshall assets. Investors also were concerned about the bank's ability to digest Marshall.

Under a definitive agreement, BMO is offering 0.1257 of its shares for each M&I share.

To keep its capital strong after the acquisition, the bank plans to issue an additional 800 million Canadian dollars (US$795.3 million) in equity before the deal closes prior to July 31, 2011. BMO also will repay Marshall's $1.7 billion in TARP debt.

The purchase bolsters BMO's position in the Midwestern states, where it operates Chicago-based Harris Bank, and will more than double its branches in the U.S. to 695. BMO has struggled to formulate a clear growth strategy since the Canadian government nixed domestic bank mergers in 1998.

"BMO had to do something. They've been in the Midwest for a long time, and this is the time to take the plunge," said John Kinsey, who helps manage C$1 billion at Caldwell Securities Ltd. in Toronto. "Most Canadian companies have not fared well at all in the U.S., so there may some execution risk."

In Toronto Friday, BMO stock fell C$4.05, or 6.5%, to C$58 on more than 13 million shares. In New York, M&I gained US$1.06, or 18%, to US$6.85